The Role of the Stock Market for the Transmission of Monetary Policy on the Real Economy

Question 2: How does the economic upswing come to an end according to the Keynesian Theory?
Economic downturn (upswing reversal) in Keynes’s model begins with a change in consumers and investors’ expectations. Downswing begins with a decrease in business and speculator confidence that reduces stock and other securities prices and also lowers investment demand. This creates a multiplier effect, where lower investment spending reduces aggregate income, which in turn forces households to reduce their spending and accumulate savings, which further decreases aggregate income. As a result, even if there is only a small initial decrease in expectations and investment, the resulting decrease in aggregate demand can be very large. This fall in aggregate demand can also fuel further declines in expectations, further multiplying the decline in demand. As aggregate demand falls, the price level also decreases which increases real wages because nominal wage sticks to the real one. Higher real wages force firms to fire workers, cut jobs and reduce production in the end. Aggregate output falls and the economy start to fall into recession.
Three possible outcomes:
1. Rise of expectations;
2. Adjusting nominal wages to full employment level;
3. Government uses fiscal/monetary policy to affect aggregate demand.

Question 3: Why is monetary policy guilty to cause business cycles according to the Monetarist Theory?
a) The central bank cannot control output in the long run. Consider the consequences of a central bank attempting to target a level of aggregate output that is greater than the natural rate of output. If the economy begins at the natural rate of output, the central bank can achieve its target by increasing the money supply and aggregate demand. The problem with this policy is that it will not work forever. Eventually, the public will increase their expected...